German Court: Substance Over Form in Transfer Pricing of Start-up Losses

Germany's Federal Constitutional Court (Bundesverfassungsgericht) issued a significant ruling on May 27, 2025 (Case No. 2 BvR 172/24) concerning the deductibility of start-up losses in intercompany transactions. The decision emphasizes that the arm's length principle, as applied under German foreign tax law (AStG), requires a holistic assessment of economic substance over rigid adherence to formal documentation.

The case involved a compensation payment of EUR 4 million made by one company to its sister company to cover extraordinary start-up losses incurred during the construction and operation of a sawmill. While the tax authorities initially allowed the deduction, they later disallowed it during an audit, citing the absence of formal written agreements for the compensation.

The lower courts upheld the tax authorities' decision, focusing strictly on the lack of written contracts. However, the Federal Constitutional Court overturned these rulings. The court stated that a formalistic approach that disregards the economic reality of the transaction violates constitutional principles. It stressed that compliance with the arm's length principle must be based on a comprehensive evaluation of all relevant facts, including implied agreements and actual conduct, aligning with OECD transfer pricing guidelines.

This landmark decision is particularly relevant for multinational enterprises, especially those with risk-limited entities or early-stage investments. It reinforces the principle that "substance over form" is paramount in transfer pricing assessments. Companies should ensure their documentation clearly supports the economic rationale and actual execution of controlled transactions, rather than relying solely on the presence of formal contracts.